The consumer staples sector is characterized by its global industry classification sector (GICS). The sector is composed of companies whose primary lines of business are food, beverages, tobacco and other household items. Examples of these companies, include Procter & Gamble (NYSE:PG), Colgate Palmolive (NYSE:CL) and Gillette. These types of companies have historically been characterized as noncyclical in nature as compared to their close relative, the consumer cyclicals sector.
Unlike other areas of the economy, even during economically slow times (in theory), the demand for the products made by consumer staples companies does not slow. Some staples, like discount foods, liquor and tobacco, see increased demand during slow economic times. In line with the noncyclical nature of the demand for their products, the demand for these stocks tends to move in similar patterns. Read on to find out why the staples sector has historically had a low correlation to the overall market, and why this sector has historically experienced lower volatility. (For related reading, see Cyclical Versus Non-Cyclical Stocks.)
Staples and Supply and Demand
Anyone who has taken a basic economics class remembers the function C+I+G = GDP, where gross domestic product (GDP) is the aggregate of consumption, investment (often referred to as business spending) and government expenditures. So, if consumption comprises such a large component of GDP, why is the sector weighting of consumer staples in the U.S. stock market only around 10% or less historically? The best explanation of this relationship is the noncyclical nature of the demand and earnings of those companies.
Staples tend to have a low price elasticity of demand. This means that the demand for these products does not change much as their prices go up or down. There are no substitutes for the products themselves; however, there are many options to shop for lower prices among suppliers. This gives the suppliers of staples little room to raise prices or increase demand for their products. Suppliers do, however, have the ability to differentiate their products by the taste, appearance or results of using their products. This leaves the producers of staples in the cross hairs of the main costs that go into making their products: commodities. (Find out how the everyday items you use can affect your investments in Commodities That Move The Markets.)
If the demand for consumer staples does not grow by much, how do the producers or sellers of staples grow their businesses and ultimately their stock prices? They have a few options:
- Reduce costs
- Reduce prices
- Differentiate their products.
Companies in the business of consumer staples can grow their profits and ultimately their stock prices by reducing costs. They can reduce their commodities costs by buying larger quantities, using hedging techniques, merging with or buying other companies, and creating economies of scale via horizontal integration or vertical integration.
We have already described the demand of staples as being low in elasticity. We also know that with competition, the same box of pasta at a high-end retailer will sell for more than at a low-end retailer. This price differentiation will be much more apparent during slower economic times when the consumer steers toward the low-end retailer.
This strategy to increase demand is used by the staple and cyclical ends of the consumer business. From cars to razors, each consumer product company tries to differentiate its product as superior in order to increase demand and give the company the ability to control the item's price.
Opportunities for Investors
The business of consumer staples is relatively low tech, composed of commodities that vary in cost, tends to be low in elasticity and shows fewer swings in demand than the cyclicals. So if this business is so boring, why would anyone want to invest in consumer staples?
One of the best reasons is slow and steady growth. Since the ebb and flow of the consumer spending cycles swings wildly with the economy, so do the profits of the cyclical companies. The staples, on the other hand, tend to move in more structured patterns - boring, maybe, but for some investors, this relative stability is just right.
Another reason for committing capital to the staples sector is the diversification benefits of owning those companies. While the sector itself may make up less than 10% of the overall market historically, the correlation between the sector and the overall market is low. (Learn how to diversify your portfolio by investing in several different sectors of the economy in An Introduction To Sector Funds and Singling Out Sector ETFs.)
The staples sector has historically exhibited a beta of .68 and a correlation of .64. Herein lies the best-kept secret of owning consumer staples: a low correlation to the Standard & Poor's 500 Index (S&P 500). It is pounded into the heads of investors to diversify their stock portfolios with holdings whose asset classes have low correlations, so they add bonds, international stocks, oil, real estate and gold. While this has worked historically, there have been times when all of those asset classes had higher correlations as they all fell and the staples sector maintained its value. This is just one of those backup singers of the market that does not get much attention until it's too late.
It's safe to say that the business of consumer staples and investing in them is boring to some people. The demand for these products does not swing up and down and they don't exhibit the flashy characteristics of their close relative, the consumer cyclical.
They do, however, offer investors an opportunity to diversify into a sector that is easy to understand, has a relatively low beta and a low correlation to the overall market. So the next time you go to buy a razor when the stock market is in a tailspin, take a look at the company that makes that razor: it might be a good time to buy its stock.